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Hewlett-Packard: Unreceivable

A closer look at H-P's cash flow statement.

After recording their best daily gain in over a year yesterday, stocks were nursing a post-rally hangover today, with the Dow(DJINDICES:^DJI) and the broader S&P 500(SNPINDEX:^GSPC) losing 0.2%.

H-P: Not as cheap as it looksHewlett-Packard(NYSE:HPQ) was the worst-peforming Dow component last year, down 45%. While the stock may rebound this year, one key fundamental metric -- free cash flow -- is more likely to decline. In the annual report it filed a week ago, H-P disclosed that it sold $4.3 billion of receivables in its fiscal year 2012, which ended on October 31 -- a 54% increase over the $2.8 billion it sold the prior year. That increase contributed 16% of the company's free cash flow in fiscal 2012. H-P's revenues are expected to contract over the next several years, so selling increasing amounts of receivables clearly isn't a sustainable means to increase cash flow, because it amounts to "stealing" cash flow from a future period.

Furthermore, receivables themselves have not been evolving in the right direction. Over the past five years, average days sales outstanding has increased significantly, from less than 43 days in the fiscal year 2007, to nearly 53 days in the year ended October 31. (Days sales outstanding is the amount of receivables on the firm's balance sheet expressed in terms of number of days of revenue.) Increasing days sales outstanding indicates that customers are, on average, taking longer to pay their bills, which is rarely positive. It may, for example, indicate that a company is forced to offer longer payment terms to achieve its sales.

Proper working capital management used to be well-understood at H-P. David Packard discussed it in a speech entitled "Growth from Performance," which he delivered at an engineering conference in April 1957. He explained that it was one of the key factors that had enabled his company to grow at an annualized rate of 42% between 1950 and 1957 -- "accomplished... without any outside capital."

With a market value that represents just 3.7 times fiscal 2012 free cash flow, H-P looks cheap statistically; however, deep-value aficionados should be aware that the denominator looks like a poor baseline figure for the company's true earnings power.